Macroeconomic Issues from a European Perspective

1. Macroeconomic Issues from a European Perspective Fabrizio Coricelli Euro-Latin Network Madrid October 9, 2002

2. Lessons fromEU Enlargement • Institutional reforms before or with market liberalization • “Real” (trade) integration hand in hand with financial integration • Safety nets key for successful reforms

3. Issues • “Real” and nominal convergence: satisfy inflation criteria while catching up in income levels. Choice of exchange rate regime • Speed of adoption of the Euro (two views) • Development of financial sector: low financial depth • Fiscal rules

4. ……..Issues • No mechanisms to avoid crises are present in the EU(currency crises in Italy, UK and Sweden at the beginning of 1990s) • Development of financial sector

5. Low financial depth Domestic Credit in percent of GDP, 2000 EURO AREA AVERAGE 140 120 Portugal and Spain (1986 enlargement) 100 80 Greece (1981 enlargement) 60 40 20 0 Malta Latvia AC-12 Poland Cyprus Estonia Bulgaria Hungary Slovenia Slovakia Romania Lithuania CEECs-10 Czech Rep. Source: IFS, Accession Countries' National Central Banks

6. Institutional Reforms… • Importing institutions (against Rodrik’s view) • May not be optimal, but more credible • Safety nets to support reforms

7. ……….lead to • Credibility bonus due to accession to EU • Accession: anchor for market expectations • Lower spreads in international borrowing • Interest rate convergence

8. Creditworthiness

9. Interest Rate Convergence

10. Potential drawbacks • Premature “eurosclerosis”: unemployment rates close to 20% in Poland and Slovakia • Large governments: high tax rates • Rigidity in labor market • Large implicit debt for pensions

11. Total expenditure (% of GDP)

12. Emerging market themes

13. Integration has not reduced volatility • Volatility is much higher than in the European Union • Although cycle is highly correlated: amplitude much higher • CEECs are small open economies

14. Correlation with EU cycle

15. Volatility(standard deviation)

16. Financial sector • Can magnify the cycle • Small and medium size firms are leading growth but they are generally cut off from borrowing and thus from the possibility of smoothing output decline • Alternative to bank credit: trade credit, higher risk (chain) • Dominant role of foreign banks does not help

17. Vulnerability to crises • Government debt: not high as a ratio to GDP • Even less in terms of tax revenues (compared to LAC) • However, large share of foreign debt (as in Lac)

18. Debt indicators

19. Externalconstraint

20. Externalconstraint….. • Ext. Debt high in terms of GDP but much lower (than in LACs) in terms of exports • FDI inflows match current account deficit • Privatization-related FDIs very large • Current flows unlikely to be sustained

21. Non-FDI flows • Pro-cyclical • Sharp reduction after Russian crisis

22. Growth and capital flowsPoland

23. Czech Republic

24. Fiscal policy pro-cyclical

25. After entry? • Full liberalization of K-flows • Short term K-flows bound to increase • Exchange rate policy? • Fiscal rules?

26. Risks ahead • Delayed entry in Euro • EU fiscal rules inappropriate • Maastricht criterion is an ex post limit on deficit with a pro-cyclical bias • Need for ex ante expenditure rules

27. Conclusions……. • Trade integration possibly an insurance for sudden capital flow reversals • Candidate countries are affected by “convergence play”: expectation of entry in the eurozone (interest rates converge and spreads on international borrowing very low)……….

28. ……..Conclusions • However, postponing accession can be a severe shock………. • Test of capability to manage large capital inflows yet to come • Exchange rate policy a key issue • Mechanisms to avoid currency and financial crises at the EU level could be devised